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This question had been puzzling me for quiet some time.
Note: I trade Indian index only excuse me if some errors

1> I understand Index is derived from set of stock. Example ES --> Citigroup, Microsoft so on.
Index will change when these stock prices change. How can Bids/Ask prices in Index futures effect index future price ?

2> Why do correlated instruments move with such precision (ES,NQ). Even if some diversion is seen for some time, they catch very soon.

The index itself is separate from the futures instrument that is derived from that index (hence it's a derivative).

With ES - you have
- the stocks
- options on the stocks (also derivatives)
- the ETF SPY
- Options on the ETF SPY
- Futures options on the ES Futures

The index itself isn't tradable - it's just a number with a set of rules as to how that number is derived. There's a company that maintains that index.

The index can't be traded but the stocks can and all the above derivatives can. The question that will drive you half insane is "which is the tail and which is the dog?"

If the above isn't enough, treasuries and currencies also have relationships with the above too.

Stat Arb strategies exist to take advantage of mis-pricing between the various instruments, so they are kept in line but there is never a single, clear leader all the time. If there was, we'd just watch that move first and trade the lagger.

To take into account all of the above before you place a trade would give you analysis paralysis. So my take on it is you trade an instrument primarily based on the information from that instrument. Then secondary, you watch market internals, related instruments for backup.

Correlations break down too - some short term and some long term. NQ is tech stocks - they can be doing well if the overall market is performing poorly.

One of the things I tell people is to not fade all icebergs - an iceberg in front of a one way market could just be stat arb and so will have no directional impact. On the other hand an iceberg in a pullback may also be stat arb but it'll still spook people out of countertrend positions and hence will still have directional impact.

I try not to think too hard about all of this to be honest.

If you have any questions about the products or services provided, please send me a Private Message or use the futures.io "Ask Me Anything" thread

This is a thinking man's/woman's question.
All derivative instruments generally have a few banks who have been charged with arbitrage responsibility. The intention is to keep indices, ETFs, options in line with the underlying basket of assets. I would advise you read some white papers on ETFs available online to see how this done.

Hi can you point to one white paper on arbitrage responsibility please ..

Price gone up $20 since I bought it 2 months ago, but hey, still just less than 2 ES points for a book that will save you much more in the short term. But being 600 pages long it might take a little longer than 'short term' to get through it all. Fantastic discussions of all kinds of traders inside, including the games played.